Investor Complacency vs. The Search for Black Swans

Viewpoints

Everyone seems to be searching for black swans. Investors typically invest in
alternatives seeking diversification and enhanced returns, but these days every
investment is compared to the stock market. Last year’s impressive equity market
performance took most people by surprise. Below are some market observations from
2017 and thoughts for 2018.

Market Observations of 2017:

Shorting Volatility: Investors’ Complacency

Growth Outperformed Value

The Push to Passive Continues

Private Equity Dry Powder

The FOMO Dilemma

Shorting Volatility: Investors’ Complacency

It seems that everyone wants to know what will spark the next equity sell-off, and one
potential risk we see is investors’ complacency with the low level of volatility. A good
indicator of this complacency is investors’ comfort taking direct exposure to short
volatility trades. Expectations of future equity market volatility is typically measured
by the CBOE’s Volatility Index (VIX). The VIX has been at historically low levels for an
extended period of time, but that hasn’t stopped investors from shorting volatility.

Volatility-based exchange traded products (ETPs) represent a relatively small portion of
the total volatility market, but ETPs provide us with an easy way to measure investors’
willingness to take direct volatility exposure. As shown on the following page, the AUM
in short volatility ETPs exceeded that of long volatility ETPs for most of the second half
of the year, and it’s usually the other way around. The growth in short volatility AUM
was fueled by a combination of rising prices and the creation of new shares. By mid-
September the number of shares outstanding had increased 35% since the beginning
of the year.

Additionally, we saw a jump in short volatility ETP creations shortly after the August VIX spike. Perhaps investors saw this as a buying
opportunity, and it turns out they were right.

Long and Short Volatility ETP AUM

Source: TCW, FactSet

Investors have long known that significant returns can be earned by shorting equity volatility, while also recognizing there
was significant downside if the VIX were to spike. Investors who were willing to take this risk were well rewarded in 2017. XIV
(VelocityShares Inverse VIX ETN) returned more than 185% in 2017 while the long volatility ETN, VXX (iPath VIX ETN) lost more
than 70% of its value. The relative stability of the VIX (which ranged from 16 to 9 in 2017), and the benefit of the contango in the
futures curve apparently persuaded investors that the potential return was worth the risk.

Performance: VXX vs. XIV

Source: TCW, FactSet

To be clear, the performance of the XIV (short volatility) and VXX (long volatility) is based on the S&P 500 VIX Short-Term Futures
Index, not on the VIX itself. The index is composed of exposures to the first and second month VIX futures contract. The shape of
the VIX futures curve is usually in contango (upward sloping) and therefore an investor who is short the futures contract will earn a
positive return even if the market doesn’t change. In 2017, the VIX fell from 14 to 11, but it was the shape of the futures curve that
generated most of the return. To put the value of the contango in perspective, at the end of 2017 the one month roll was worth 8.7%
(not annualized) and as a result investors were getting paid more than just pennies for standing in front of this steamroller.

Even in this benign volatility environment there can be significant volatility. On August 10, 2017, the VIX Short-Term Futures Index fell
almost 20%, opening at 11.5 and closing at 16.0. Imagine what would happen if there were to be a 2008-type spike in the VIX? There is
good reason that the front page of the XIV prospectus warns in bold letters “…you are likely to lose part or all of your initial investment.” We see potential risk with respect to the rapid unwinding of this short volatility trade. A significant spike in volatility would lead to
large losses in the short volatility positions. If these losses were met with redemptions of these ETPs then in theory this could push
VIX futures prices higher and therefore short volatility ETP prices would drop, resulting in further selling. It is important to reiterate
that volatility ETPs are a small part of the volatility market. Since the early days of VIX ETPs, much has been written about the concept
that the buying of VIX ETPs could drive a sell-off in the equity market, but to-date we have not seen that event materialize.

Growth Outperformed Value

The S&P 500 Index returned 21.8% in 2017. The top 10 contributors represented almost a third of that return and most of that came
from growth companies. It is no surprise that last year’s strong stock market performance was driven largely by growth stocks, and
more specifically by certain tech stocks. FAAMG – Facebook, Apple, Amazon, Microsoft, and Google (Alphabet) – represented 23.7%
of the S&P 500’s performance. Growth significantly outperformed value in both the large and small cap markets in 2017, as outlined
in the table below.

2017 Index Returns

Source: TCW, FactSet

While it can be helpful to look at last year’s returns, the more important question is, will this relative outperformance continue in 2018?

Obviously, growth and value stocks do not move in lock-step, and in some instances, such as in 2015, they move in different
directions. In answering the question posed above, it is important to think about the drivers of performance, and what might cause
growth to continue to outperform so significantly.

Growth vs. Value Index Returns

Source: Standard & Poor’s, FTSE Russell Indices

A similar picture appears when we compare growth versus value in the small cap market. The Russell 2000 index is not as
concentrated as the S&P 500, but the top 10 contributing stocks still represented 15% of the performance of the overall index, and
the top 10 is dominated by growth companies.

Unlike the late 1990s, the outperformance in tech was not driven simply by an expansion of price-earnings ratios (P/E). While P/E did
grow, earnings did as well. The table below presents the change in P/E over the past 12 months.*

Price/Earnings Ratios

Source: TCW, FactSet

One reason that this relationship might persist in 2018 is that investors like to buy winners. Another reason that growth stocks may drive
performance in the coming year is the continuation of the trend toward passive management. The weighting of FAAMG in the S&P 500
Index is now 13.3%, so for every $100 being invested in the S&P 500 Index more than $13 is being invested in these tech companies.

The Push to Passive Continues

The further shift from active to passive investment management could result in a continuation of last year’s trends. By our calculation
approximately 48% of ’40 Act U.S. large cap equity assets are now managed passively, and we know anecdotally than many large
institutional investors are following a passive approach to managing their developed market equity exposures. This means that a
company’s weight in the index is becoming more important than the market’s view of its future prospects – increasingly capital
allocation is being based on index weighting not the market’s assessment of intrinsic value. Said another way, the big expensive
companies attract the capital.

Last year’s top 10 contributors to return accounted for 15.9% of the market cap of the S&P 500 Index at the end of 2016, and by the
end of 2017 their combined weight had climbed to 18.6%. If we focus on tech, FAAMG’s weight in the S&P 500 increased by 20%
during the course of the year. If investors continue to chase returns, then this weight is likely to continue to increase.

Large Cap Flows

Source: TCW, Morningstar

The story has been similar in the small cap market but to a lesser degree. The flow from active to passive investing is continuing, but passive
investing represents just less than 40% of the ’40 Act market. As mentioned earlier, the small cap market is also much less concentrated
than the large cap market. The top 10 return contributors in the Russell 2000 Index had a weight of only 1.7% at the end of the year.

We see this move to passive management as a double-edged sword for active managers: It should create more opportunities for
sophisticated investors, but it will probably take longer to realize those opportunities as there would be less capital seeking mispriced
companies. The opportunities are likely to be the greatest in the small cap market where many of the companies are not even covered
by Wall Street equity analysts.

Small Cap Flows

Source: TCW, Morningstar

Private Equity Dry Powder

Another observation of 2017 was the continued growth in assets in private equity. The returns in private equity have been impressive
in recent years, and investors have been flocking to this market as a way to improve overall portfolio returns – regardless of the
inherent equity beta. Clearly the run-up in the equity market over the past nine years has been a tail wind for private equity funds but
it may also have made it more difficult to invest new assets. Based on information from Preqin, both annual new assets raised and
cumulative dry powder in the private equity market has continued to grow.

Private Equity Flows

Source: Preqin

Generally speaking, private equity managers gravitate toward value stocks because these types of companies have the capacity to
handle higher debt loads. That preference, combined with the large amounts of capital private equity funds have at their disposal,
suggests that private equity may be able to provide a safety net of sorts for value stocks, at least relative to growth stocks.

The FOMO Dilemma

Most investors tend to be concerned about equity valuations,
but they are also reluctant to significantly reduce their exposure
to the equity market. It’s the fear of missing out (FOMO) that
seems to drive this behavior. Twelve months ago, few, if any,
investors were expecting the S&P 500 Index to return over 20%
in 2017, but then they were not expecting a 12% return in 2016.

Black Swans

Investors want to generate returns to meet targets/obligations, and it is difficult to generate those returns when the risk-free rate
is hovering around 1.5%. We are in situation in which investors are:

Stretching for yield by taking short volatility positions

Investing passively in an index that is becoming increasingly concentrated in technology on both a market value and risk basis

Resisting the desire to reduce equity exposures for fear of missing out on the next rally

We believe that portfolio diversification is important and that the trends we’ve observed are resulting in less diversification.
Additionally, the tendency to view dips as buying opportunities only delays the inevitable correction. While these are not black
swans, we believe they do contribute to overall market risk – just as portfolio insurance was not a black swan in 1987.

Achieving diversification doesn’t mean simply looking at historical correlations and standard deviations – neither is constant and
the numbers don’t reveal the entire risk story. It is important to understand the source of returns and risks and to think about how
those returns may correlate in the future, especially in the event of a crisis.

One way to de-risk and stay in the equity market is to invest in value stocks. While an equity sell-off would probably also impact
value stocks, they have not experienced the significant run-up that the growth stocks have experienced. Additionally, the dry
powder in private equity funds could provide some support for value stocks in that environment.

Alternative strategies that have low beta to the market should also be attractive. Again, you want to be comfortable that the low
beta relationship would persist in an extended market drawdown. Additionally, the move to passive management should result in
more opportunities for active managers, especially in the small cap markets where there is little-to-no analyst coverage.

The inspiration for writing this piece was my personal search for black swans at the end of 2017. I’m pleased to say that I found
them swimming on Meroo Lake on the South Coast of Australia. The search for black swans reminded me of the old Wall Street
adage, “the market moves in the direction that hurts the most people.”